Bond portfolios usually take a back seat to stock portfolios when it comes to popularity. While they play an essential role in overall asset allocation, bonds don't seem to get the same attention as their much jazzier stock-based cousins. They are often constructed as an afterthought or sit untouched for years, generating income. That is unfortunate because bonds provide a hybrid—sharing and blending the risk and return characteristics of stocks and cash.
Properly constructed bond portfolios can provide income, total return, diversify other asset classes, and be as risky or safe as the designer desires. The fixed-income world is as diverse and exotic as the stock market.
Key Takeaways
- Bonds are a vital component of a well-balanced portfolio.
- Bonds produce higher returns than bank accounts, but risks remain relatively low for a diversified bond portfolio.
- Bonds in general, and government bonds in particular, provide diversification to stock portfolios and reduce losses.
- Bond ETFs are an easy way for investors to gain access to the benefits of a bond portfolio.
How a Fixed-Income Portfolio Works
First and foremost, bonds are designed to provide income to the bondholder in return for lending the money to the issuer. The path of the coupon payments from the issuer passes to the transfer agent, the bank, and the bondholder. In its simplest form, a 3% bond with a face value of $1,000 that is trading at its par value would yield $30 (3% of $1,000) of income to the holder each year in the form of coupons.
It is easy to forget that the word "coupon" used to mean actual coupons that were clipped from the bond. Earlier in the 20th century, bondholders were given a coupon book with their bond and could go to the bank and present the coupon of payment or deposit. This process has evolved, making it much easier not only to buy and sell bonds but to receive coupons as income. Bonds are now held in what's called street names, which provide an easier and safer way of owning bonds.
The bonds can also be used in an account as collateral for loans, including margin loans to purchase other bonds, stocks, and some funds. Bonds are quite versatile and are excellent liquid vehicles for meeting investing goals and objectives.
Bond Income and Taxation
Bond income can be either taxable at the federal rate or exempt from federal tax. You might have heard about municipal bonds, or "munis," as tax-exempt alternatives to corporate bonds. Beyond that, there are many variations in taxes at the state and local levels. In general, bond income is taxable as income, whether filing as an individual or company. That is a disadvantage for bonds, as folks who favor stocks will quote that the current bond market yields a negative real return.
While that sounds impossible, here's an example:
| Principal | $100,000.00 |
|---|---|
| Coupon | $4,000.00 |
| State Tax | -$280.00 |
| Fed Tax | -$800.00 |
| Inflation | -$3,000.00 |
| Real Return | -$80.00 |
This example shows a principal of $100,000 invested in a bond paying a 4% coupon, taxed at the federal and state levels. Deducting the loss of purchasing power with a Consumer Price Index (CPI) value of 3% nets a negative real rate of return. However, be aware that there is some controversy over the CPI as a measurement of inflation.
On the flip side, using a bond with coupons that are exempt from taxes at the federal and state levels creates a different outcome:
| Principal | $100,000.00 |
|---|---|
| Coupon | $4,000.00 |
| State tax | $0 |
| Fed Tax | $0 |
| Inflation | -$3,000.00 |
| Real Return | $1,000.00 |
It is also possible to avoid taxes on bond income by holding them in a tax-exempt retirement account, such as a Roth IRA.
How Bonds Benefit Investors
While positive, a 1% return is not very impressive, considering the potential gains in the stock market. These examples could quickly drive a novice investor away. However, there are reasons why both individual and institutional investors require bonds as part of a balanced portfolio. The main reason is that coupon income is only one component of the bond portfolio's total return. Also, the low correlation of bonds, as an asset class, with equity asset classes provides some stability through diversification.
Total Return
A bond portfolio's total return is the overall change in its value during a specified time interval, including income and capital appreciation or depreciation. Market value fluctuations, and ultimately risk characteristics, are affected by interest rates as measured by the yield curve. The interest rate environment is dynamic. As a result, the source of the return is not only the prevailing rate on a static yield curve. It also includes price changes caused by fluctuating interest rates over the time period.
Diversification
As an asset class, bonds help diversify the overall portfolio because of their low correlation to other asset classes. The lonely bond portfolio always shines brightest when equity markets slump. While the correlations vary widely over time, bonds are not highly correlated with any other asset classes. Even in the simplest diversified portfolio, bonds can reduce volatility due to their low or negative correlation with stocks. The more that investors learn about diversification, the more likely they are to add bonds to their portfolios.
Making Bonds Easy With ETFs
Investors do not have to become bond geeks or learn how to be bond traders to buy bond ETFs. Bond ETFs can be purchased just like stocks and give investors instant access to ready-made bond portfolios. Aggregate bond ETFs provide access to the entire investment-grade bond market. They are ideal for investors who are looking for something relatively low-risk with a higher return than the money market. However, those who want to safeguard their stock holdings are better off with government bond ETFs. Government bonds often go up in price when stock prices fall, so they provide more protection.
The Bottom Line
Bonds have typically been viewed as less-glamorous sidekicks to stocks. Many investors think bonds are boring and complicated, but ETFs make them easy. There are a lot of interesting options in the bond market, too. Buying U.S. government bonds during a bear market for stocks can be far more profitable and exciting than waiting around in cash. When investors expect a bear market to end, junk bonds are often a higher reward and lower risk choice than stocks. Finally, a highly diversified bond portfolio is an easy way to make a little more money than cash with a little more risk.
Article Sources
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Internal Revenue Service. "Tax Exempt Bonds."
Internal Revenue Service. "Topic No. 403, Interest Received."
Internal Revenue Service. "Publication 550 (2022), Investment Income and Expenses."
U.S. Securities and Exchange Commission. "Beginners' Guide to Asset Allocation, Diversification, and Rebalancing."
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